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Thursday, January 26, 2012

Deflation: Economic Significance, Current Risk, and Policy Responses

Craig K. Elwell
Specialist in Macroeconomic Policy

Despite the severity of the recent financial crisis and recession, the U.S. economy has so far avoided falling into a deflationary spiral. Since mid-2009, the economy has been on a path of economic recovery. However, the pace of economic growth during the recovery has been relatively slow, and major economic weaknesses persist. In this economic environment, the risk of deflation remains significant and its occurrence could derail sustained economic recovery.

Deflation is a persistent decline in the overall level of prices. It is not unusual for prices to fall in a particular sector because of rising productivity, falling costs, or weak demand relative to the wider economy. In contrast, deflation occurs when price declines are so widespread and sustained that they cause a broad-based price index, such as the Consumer Price Index (CPI), to decline for several quarters. Such a continuous decline in the price level is more troublesome, because in a weak or contracting economy it can lead to a damaging self-reinforcing downward spiral of prices and economic activity.

However, there are also examples of relatively benign deflations when economic activity expanded despite a falling price level. For instance, from 1880 through 1896, the U.S. price level fell about 30%, but this coincided with a period of strong economic growth. Whether a deflation is on balance malign or benign most often will hinge on whether the force generating the falling price level is collapsing aggregate demand or accelerating aggregate supply. Both forces exert downward pressure on the price level but have opposite effects on the level of economic activity.

Deflation can dampen economic activity through several channels. First, a falling price level will increase the real (inflation adjusted) cost of inputs, raising the unit cost of production. Second, when nominal interest rates are low, as they are now, deflation could increase real interest rates, dampening credit-supported economic activity. Third, deflation will increase the real debt burden of businesses and households that already hold debt because they will be repaying the loan principal with dollars of rising purchasing power.

The expectations of households and businesses about the future path of the price level will influence deflation’s persistence and the difficulty of stabilizing the falling price level. The expectation of further deflation can in theory create a self-reinforcing downward spiral that deepens and prolongs the fall of economic activity as households and businesses adjust their economic outlooks. To avoid that outcome, government would likely need to take policy actions that not only counter the current negative demand shock and constricted flow of credit to the economy, but also create the expectation among economic agents that the future price level will be higher than the current price level; in other words, government would need to convince economic agents to expect inflation rather than deflation.

Economic policy can in theory contain or mitigate the negative effects of a deflation caused by a negative demand shock. The conventional macroeconomic policy tools of monetary and fiscal policies could be used to support current aggregate spending and exert upward pressure on the price level, although currently high deficits restrict fiscal space for movement and policy interest rates at zero pose a challenge for the monetary authority.

Date of Report: January 1
2, 2012
Number of Pages:
Order Number: R4
Price: $29.95

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